I was reading the news one morning last week and noticed that Coach reported earnings that disappointed and the stock was off 8%. I’ve never really looked at Coach and don’t know much about the company, but I glanced at some of the numbers and was impressed by how strong the business appears to be.

Although I prefer investing in stocks that are cheap and obviously undervalued, I’m always looking at great businesses to study them and learn more about them, as occasionally they are offered up as bargains by Mr. Market. I have a database of great companies I track on a spreadsheet watchlist I created from paging through Value Line. These are companies that have certain quantitative characteristics of great companies–things like high margins, consistent free cash flow generation, high returns on capital, etc…

I thought I’d write an intro post on what I look for when trying to identify quality. This is not going to be comprehensive, just a summary of the basic numbers. Reading through Value Line day after day, I have gotten efficient at quickly identifying a few common data points that are relevant across most businesses.

Once you practice this type of analysis, it can be done in 1-2 minutes per business. It’s a procedural memory thing… I know what to look for to quickly get a basic handle on what I’m dealing with. I find ideas through reading Value Line, the paper, blogs, 13-f’s, etc… and then use Morningstar or GuruFocus to look up some quick data points to tell me if I should dig deeper. It’s not complicated. No Bloombergs needed, no fancy spreadsheets allowed…

So whenever I read something that prompts me to take a quick look at a stock, a minute or two is all the time I need to initially spend on it to tell me if I should read the filings and annual reports and begin to dig deeper.

Coach-Possibly a Very Good Business

At this point, I don’t know if Coach (the stock) is a good value, but I do think Coach (the business) appears to be a great business. The vast majority of the time, these businesses collect dust on my watchlists as most great businesses are priced accordingly.

Investing is all about returns on capital invested, and those returns can come from buying undervalued assets or quality businesses. Often times, the former gets priced more cheaply relative to intrinsic worth than the latter, and so we go where the largest discounts are to fair value. But if you want to study businesses, study the great ones, as ideally—as business owners—those are the ones we’d like to own. The best ones can create a significant amount of value for shareholders over a long period of time.

I’m steadily building my database of businesses, and that knowledge accrues over time—as Buffett says, it’s like compound interest.

Just to reiterate, I haven’t done any research on Coach other than glancing at the numbers very briefly. This post is not a recommendation, or even a suggestion that the stock is a good value (although it might be).

I just thought it would be beneficial to post some brief numbers to show a snapshot of what I like to look for in a good business. Coach certainly appears to be a good business based on the numbers. It’s an asset light business that produces high returns, high margins, consistent free cash flow, and it’s growing.

I plan to read the filings and I just emailed the IR department and requested a hard copy of the recent annual report (why is it that reading hard copies of annual reports are so much more enjoyable than reading them off the screen?). I might follow up with some more details at some point.

For now, let’s glance at the numbers to see what a good business looks like. These are just basic summary numbers I pulled from Morningstar and Guru Focus.

First, take a look at some overall summary numbers over the past 10 years:

COH-10 yr data

The company is growing at consistently high rates. Sales, earnings, cash from ops, free cash flow, and net worth are all growing substantially. The business has very high margins, Sales per share growth has averaged about 20% per year over the past 10 years:

COH-Rev per share

They have achieved high revenue growth, but they’ve also generated consistent cash flow growth. Better yet, their reinvestment needs (total capex) is quite low for such a growing enterprise. So the business throws off a lot of cash, and that cash stream is growing. One of my favorite parts of this business is their high margins: Look how efficient they are at turning sales into free cash flow. They turn every $1 of sales into about 23 cents of FCF (10 year data from 2003 to 2013):

COH-Cash flow numbers

Here is a look at their other margins, which just based on the numbers would indicate the possibility of an economic moat with around 70% gross margins and 30% pretax margins:

COH-margins

A business like Coach uses a relatively small amount of tangible assets in the operations of their business, so normal price ratios to book values don’t tell much about value. However, I do like to look at the progression of a firm’s net worth over time because this is often a great way to look at shareholder value creation over the long term. Coach’s net worth has been growing at a rate of about 14% per year over the past decade:

COH-book value growth

One of my favorite ways to quickly look for signs of quality is to look at the returns on equity or total capital that a firm produces. As I page through Value Line, this is one of the first lines I look at. Return on capital is a simple measure to determine how much money the company is producing for its owners on the capital that they’ve invested (ROC generally includes both equity and debt capital, so I prefer ROC to ROE because it adjusts for leverage to give you a true picture of how good the business is).

In this case, ROE is basically the same as ROC because Coach is very lowly levered. As you can see, Coach produces incredibly high returns on their assets and equity:

COH-profitability

Return on equity (ROE) has three possible drivers:

  1. Profitability (net profit margins),
  2. Efficiency (asset turnover, or sales/assets), and
  3. Financial leverage (assets/equity)

In Coach’s case, their incredibly high returns are due to their high margins. They are able to mark up their merchandise significantly over their costs of that merchandise (COGS). And we know margins are driving the returns because the asset turnover is modest and Coach has an extremely healthy balance sheet very basically no debt and over $1 billion in net cash.

Finally, a quick look at their common-sized balance sheet (numbers are listed in % of assets, which makes it easy to compare line items):

COH-Balance sheet data

As you can gather from taking a quick look, the business uses very little fixed assets (it’s “asset-light”) to produce their earnings. Total liabilities are only 31% of total assets, and there is basically no long term debt.

The company is very liquid and has healthy financial leverage ratios. The Current Ratio measures current assets to current liabilities (the ability the company has to meet its current obligations). Quick ratio is a more liquid and conservative measure that uses only cash and receivables (excludes inventory) and compares that sum to current liabilities. These data points are more useful to evaluate businesses that may have questionable strength. In Coach’s case, the business is clearly not at any immediate risk of a liquidity problem or long term leverage problem.

So collectively, these data points show the signs of a quality business.

Obviously, as investors, we need to figure out if the shares are undervalued. Ultimately, we’d like to arrive at a valuation of the business and establish a margin of safety between that valuation and the share price. One quick comment I’ll make is that while I haven’t done any detailed work, I like situations like this because the business looks interesting and a quick look at common value metrics show that the valuation isn’t overly exuberant at these prices.

Here’s a look at the 10 year progression of the Enterprise Value to Earnings before Interest and Taxes (EV/EBIT is Greenblatt’s preferred earnings multiple because it accounts for leverage and adjusts for varying tax rates, which the P/E ratio does not).

COH-EV to EBIT

In this case, this valuation metric looks to be fair for a high quality business, thus the reason I thought I’d summarize the numbers and mention that Coach might be worth looking at further.

To Sum It Up:

Coach is a great business that produces high returns on capital and has very high margins. The business has produced positive free cash flow in each of the last 10 years, and that cash flow has grown steadily and significantly.

I don’t know if Coach will continue to grow, and I’m uncertain of its durability, but looking at the last 10 years’ worth of data shows the portrait of a great business. As Buffett said, investors don’t profit from historical growth, so further evaluation is needed to determine the likelihood of the business being able to continue producing these impressive returns.

I thought a basic intro post into some things I like to look for in quality businesses would be of interest to some readers.

Best of luck in your search for value…

 

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16 Responses to Coach (COH): An Overview of the Numbers

  1. MP says:

    Another great post as usual, John. Thanks for sharing some of your thought process.
    I’m long COH and I’m looking for them to continue their growth with international expansion with affordable luxury – although that might increase their CapEx. I may be optimistic but I think they are currently valued as if they are done with their growth so I’ve been adding to my position with the recent price drop.

  2. Handworn says:

    COH has been a stock much discussed by the guys on the radio shows / podcasts at The Motley Fool. Some like it, but someone just recently was saying that it’s losing its status as a luxury brand. They chatted a little about that but I don’t remember them citing any particular number in support, so I’m unsure what their argument is. Likely it’s at the website.

    Anyway, I agree that the numbers look appetizing, but speaking personally, I don’t associate Coach with luxury and nothing but, the same way I do some of the stronger brands, like Tiffany or Louis Vuitton. I’d say that until things become a bit clearer or I know more things I’d stay away.

  3. jimmy egan says:

    on why paper > screens in lengthy readings

  4. Turn says:

    Can you explain what do you look for in your 1-2 minute analysis? I’m very interested in developing the procedural memory. What are the things you look at, that determines whether you dig in further or not?

    For me it’d would be the Greenblatt formula or if it’s ridiculously cheap on an asset valuation. That would make me dig further to make sure all of that is true.

    On an another note. What do you think of buying a basket of negative EV stocks? I remember reading in Old School Value, that you just have to buy 20 of these for a year. Mechanistic strategy basically. I was thinking of filtering them by country, because it seems that Asian countries tend to have more fraudulent activities and what not.

    • John Huber says:

      Thanks for the comment. I really just look for basic things like valuation metrics to see if it looks cheap on the surface. But as I flip through Value Line, I’m glancing very quickly at the 10 year history of the business through the numbers. Things like, what is the book value growth (I always prefer to see compounding net worth over the last 10 years, as that is a simple way to see if shareholder value is getting created). What are the returns on capital? What are the margins? I like to look at the 10 year history to see how the business has been performing.

      All of these things are factors that determine value. The glance at the numbers is just a quick way to determine the overall picture. Knowledge builds up after doing it over and over.

      As Greenblatt said, the two most important factors are Return on Capital and Valuation (he liked EV/EBITDA less capex, or EV/EBIT-which is what he used in his magic formula).

      As for negative EV stocks… I think of them the same way I think of net nets. Many of them are crappy businesses. Some will not survive, some will continue to be priced around the same level indefinitely, and a few will appreciate by multiples. It’s very difficult to predict which ones will perform which way, because they usually all have problems, so a basket approach gives you diversification and increases the probability of achieving the expected result. The expected result-according to research and practice-is quite good.

      I don’t practice a mechanical strategy, and I feel more comfortable understanding something about the businesses I own, but over time Graham’s net net or the negative EV strategy have proven to be very successful.

      For mechanical strategies, I like Greenblatt’s the best because the companies are earning above average returns on capital and are often good businesses that have been priced low for some sort of reason.

      But buying junk can work, as the market consistently undervalues these things. But caveat emptor applies…

  5. Robert says:

    Very nice writeup. Two things – 1) where are you generating the graphs? I know the tables are from morningstar but I don’t recognize the graphs. 2) Here’s a link to a nice research report on the bullish case for COH. http://www.marketfolly.com/2013/03/the-bull-case-on-coach-coh-from.html

  6. Greg S says:

    John,

    Thank you for sharing your thoughts. I always appreciate your posts.

    Coach has been on my watchlist for awhile for exactly the reasons you outline here. Last time I looked at it, my feeling was that if the sales were flattish (keeping up with pop./econ growth) it was fairly valued in the $50s. It would probably do ok with good use of FCF, but wouldn’t do really well unless the business turned around and started growing again, and there was risk of continued degradation.

    My question for you is this – after looking at the financial metrics for a company like this, which I agree are great, what would you do to assess the business prospects going forward? Obviously, we’re talking about the fickle fashion industry here. I’m curious about your approach to this question.

    Greg

    • John Huber says:

      Good question Greg. That of course is the difficult part, and the one with the largest room for error. But it starts for me by reading the filings and trying to get a feel for how the company operates, who their competitors are, etc… I try to look for businesses that are fairly predictable. But there will always be errors in judgment, as the future is invariably unpredictable, so I prefer to buy stocks very cheap. That way, I’m not paying much for continued success going forward. When the market is expecting dire results in the next few years, that’s when I feel more comfortable because I don’t have to rely on the company performing up to my expectations–and if they do, then the investment works out very well.

      But I do like to understand what I own, and the filings (10-K’s, 10-Q’s, etc…) are the best place to learn more about the business model. The reading competitors’ 10-K’s will also give you another view of the same business model. All of this builds up over time, making the decision process more efficient.

      The other thing I like to do–which is always more quantitative–is go back through many years of history (the filings often let you go back into the late 90′s) to see how the company performed in various economic environments. The financial crisis is a good measure and you don’t have to go back far.

      Keep in mind that there will always be mistakes, but try to mitigate them by removing valuation risk (paying too much) and leverage risk (try to avoid things with too much debt on the balance sheet in most cases). These two cause a lot of unforced investment errors.

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